Hong Kong, Sterling, and the Dollar

The second half of the 20th century has seen a lot of change in the world’s monetary arrangements. In the years after the Second World War was brought to an end, the Bretton Woods system tried to restore monetary order, reviving some elements of the interwar years’ gold standard and combining this with some new international coordination. Currencies were fixed to the U.S. dollar, or in some cases sterling which was in turn linked to the dollar. After the end of the Bretton Woods system, in the 1970s, more countries adopted floating exchange rates. However, in a departure from the trend towards floating exchange rates, Hong Kong eventually returned to the U.S. dollar and as a result offers an interesting case.

Sterling Peg

Hong Kong reformed its monetary system in 1935. Previously, the British-governed city-state operated on a silver standard, like mainland China. Under the new system, each Hong Kong dollar banknote was backed by sterling with a 100% reserve ratio. These reserves were managed in London in a manner not unlike that of other colonial monetary systems in the British Empire.

This system of pegging a currency to another and backing the former with reserves in the latter currency whose value exceeds, or at least matches, the value of the local currency outstanding is referred to as a ‘currency board’. Compared to other currency pegs, a currency board has considerable credibility. If people demanded, they could exchange their Hong Kong dollars for sterling and there would never be inadequate reserves to maintain the peg, even if every Hong Kong dollar banknotes was redeemed. Essentially, the entire money supply could be swapped for British pounds if need be. This credible currency regime was thought responsible for some portion of Hong Kong’s considerable economic growth after 1950 even though sterling was devalued in 1949 and 1967.

The Currency Ordinance of 1935 formed Hong Kong’s new ‘Exchange Fund’, crucial to the maintenance of the currency board. In practice, it functioned as follows: private banks like the Hongkong and Shanghai Banking Corporation (HSBC) issued Hong Kong dollar notes and, in order to legally do so, were required to credit the new Exchange Fund’s account in London with sterling deposits. The fund then provided the banks with certificates of indebtedness, denominated in Hong Kong dollars, to the value of the banknotes they planned to issue; the certificates would collateralize the banknotes.

The Exchange Fund money was not only invested in liquid U.K. Treasury bills though. After the 1950s, 30% of these assets were permitted to be invested locally in Hong Kong. These could be difficult to liquidate in a severe crisis which affected demand for Hong Kong assets. Also, in the 1960s, up to 70% of reserve assets could be invested in less liquid U.K. investments. These were long-dated bonds which could earn a greater yield but whose value could be more volatile and less easily converted into liquid funds.

Early Years of Instability

After the Second World War, the remaining life of the currency board overlapped with the Bretton Woods system, the international monetary system that came into operation in the decade or so after the war. However, this system did not last; it was flagging by the late 1960s. In 1967, the British devalued sterling by 14.3%. In order to limit the impact on local cost of living, the Hong Kong Executive Council devalued by only 5.7%, meaning that the Hong Kong dollar appreciated relative to sterling by about 10%.

Also in 1967, Hong Kong was facing its own local difficulties. There were riots in the city that triggered a run on Hong Kong banks. This bank run led monetary authorities in the city-state to consider issuing new banknotes against the value of local assets, rather than sterling assets, but was not resorted to. Had that been done, it would have been a departure from the currency board system.

In a patch to keep the sterling area together, the British were willing to protect some foreign holders of sterling reserves from the harms of that country’s devaluations. The 1967 revaluation, for example, had meant that the value of sterling assets backing Hong Kong dollars had fallen, representing a loss to the Exchange Fund.

To protect the city from this, the British agreed in 1968 to guarantee the Hong Kong dollar value of 50% of the city-state’s sterling reserves in the event of a future devaluation. Later that same year, in one of the ‘sterling agreements’ designed to address the retreating role of sterling as a reserve currency, Hong Kong agreed to keep 99% of its reserves in sterling but with the condition that 90% of the U.S. dollar value of these reserves was guaranteed. Britain secured a line of credit from G10 economies to back up this guarantee.

Because of this guarantee, Hong Kong’s reserves in sterling grew from under £400 million at the end of 1968 to over £700 million three years later. Some of these were private banks’ reserves taken over by the Hong Kong Exchange Fund so that these reserves could benefit from the British guarantee, which was extended only to official reserves and not private holdings of sterling assets.

End of Sterling Peg

Sterling was revalued slightly with the December 1971 Smithsonian Agreement, taking the pound from $2.40 to $2.60 to the pound, a modest strengthening. However, starting from June 1972, sterling was allowed to float in value as the peg to the U.S. dollar was cut. At the end of 1971, Hong Kong was the largest holder of sterling reserves, so it had the most at risk outside Britain itself. Its balance of £703.6 million exceeded even that of larger countries like Australia (with £637.2 million).

After sterling began to float freely, Hong Kong could have maintained the link to sterling, allowing its currency to change in value day-by-day against most other currencies like the U.S. dollar. Instead, it chose to link the currency to the U.S. dollar directly, though this was short lived. Initially, there was no requirement to maintain U.S. dollar reserves sufficient to back every Hong Kong dollar. There were multiple barriers to requiring such. Firstly, reserves remained in sterling because of earlier commitments and because it was not straightforward to raise new reserves in U.S. dollars from the relatively small market for American dollars in Hong Kong. Also, selling sterling for U.S. dollar assets would have also entailed recognizing large losses on these reserve assets.

Regardless, the U.S. dollar’s own link to gold was not to last much longer anyway. The US dollar was itself devalued by 10% in February 1973; that year, the Bretton Woods system ceased to exist altogether. Hong Kong’s Executive Council decided to maintain the value of the Hong Kong dollar in gold terms rather than follow the American devaluation. This meant the Hong Kong dollar appreciated 11.1% against the U.S. dollar. This was not exactly a triumphant moment. In the period from 1972-74, Hong Kong had to grapple with a global monetary and energy crisis as well as a large domestic stock market crash.

Still, the Hong Kong dollar was not truly floating freely. During this period, the monetary authorities were intervening to keep the value of the Hong Kong dollar from exceeding the upper end of the band in which it was permitted to trade. This entailed buying U.S. dollars. If the state had not intervened in this way, the Hong Kong dollar would have appreciated. This appreciation might have been helpful in quelling inflation; the end of the Bretton Woods system contributed to inflationary pressure. However, Hong Kong could not fight inflation freely since such policies would likely strengthen the Hong Kong dollar too much.

The restraint was abandoned entirely for in 1974, the Hong Kong dollar was allowed to float freely. Curiously enough, while it had a currency to manage on its own now, Hong Kong did not establish a central bank. Rather, the private Exchange Banks Association, led by HSBC, set deposit interest rates and interbank rates were set by a free market. The government influenced but did not direct these processes.

Even into this new regime, the Exchange Fund continued to exist, housing Hong Kong’s foreign currency reserves. The fund was augmented with money from the government’s own fiscal reserves in 1976. This money was no longer used to back banknotes at a fixed rate so it could be applied to all sorts of purposes; it was turned to in order to bail out banks during the city-state’s periodic banking crises for example.

U.S. Dollar

After a few years with a floating exchange rate, Hong Kong eventually returned to a U.S. dollar peg. This was partly the result of a desire to stem capital flight associated with the turbulence of talks to eventually hand over Hong Kong to the People’s Republic of China. There was also a property sector led boom-tuned-bust in the city-state in the early 1980s. It was a period of great difficulty for Hong Kong. The city was facing competition from Singapore as the premier financial center in this part of Asia. Also, while Hong Kong’s inflation was getting out of hand, the United States had begun to more effectively control price rises starting with Paul Volcker’s tenure at the Federal Reserve from 1979 on.

The Hong Kong dollar weakened considerably in September 1983 and the financial system looked fragile; the government had to take over a mid-sized bank, Hang Lung Bank. The bank was bailed out with money from the Exchange Fund, still in existence after nearly a decade following the abandonment of the old pre-1974 currency board.

In response to this ‘multi-crisis’, a new currency board regime was established to back Hong Kong dollars with U.S. dollars at a rate of 7.80 Hong Kong dollars to the U.S. dollar. In doing so, Hong Kong was bucking a trend. Overall, more countries were breaking pegs to the U.S. dollar than were creating new ones. Between 1976 and 1989, the proportion of countries with currencies linked to the U.S. dollar fell from 43% to 24%. Yet, Hong Kong’s currency board was to last. In 1984, the Sino-British Joint Declaration, which outlined the ‘one country, two systems’ approach to Hong Kong, was signed, respecting the monetary distinctiveness of Hong Kong vis-à-vis mainland China.

Lesson

Countries have often pegged their currencies to others to maintain stability for trade and finance. However, this stability may not last and not every currency peg is equally convincing. At the first sign of trouble, when capital flight starts, these weaker pegs might fail. A currency board is more convincing and stable; however, these are not permanent either. The Hong Kong dollar’s peg to sterling had considerable creditability but it did not last and the current peg to the U.S. dollar might not last either. Even if the peg ‘can’ be maintained, the policy may become undesirable for some other reason than immediate financial pressure and consequently abandoned just as the Hong Kong dollar’s peg to sterling was.

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